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Can Fed Rate Cut Overcome Stock Recession Nightmare?

June 05, 1995|TOM PETRUNO

Now comes the acid test for stocks' bull market.

A sequence of government and private-sector reports last week described an economy slowing so drastically that a recession may be unavoidable.

The prospect of actual shrinkage of the economy--instead of the heretofore expected "soft landing" of very slow growth--clearly gave some investors pause on Friday, as the Dow Jones industrial average fell 28.36 points from Thursday's record high to finish at 4,444.39.

But the broader market still advanced on Friday, suggesting that most investors either don't consider the threat of recession to be real, or for their own reasons don't believe that recession would necessarily be fatal for the bull market.

Skepticism about an official recession--defined as at least two consecutive quarters of contraction in the nation's gross domestic product--isn't unreasonable, of course. Government data on the economy can be dangerously misleading in the short run, and reports showing surprising weakness may later be revised upward.

What's more, there are plenty of investors who believe that the economy's next move isn't as important as the Federal Reserve Board's next move. If the Fed begins to ease credit to prop up the faltering economy, the stock market is likely to view that as inherently bullish, some Wall Streeters insist.

But if a true recession is in fact looming, can stock prices really avoid a deep pullback from their current lofty levels? History doesn't provide a comforting answer to that question: Since 1945 there have been nine official recessions, and every one of them has been preceded or accompanied by a sharp decline in stocks.

In the typical pattern of events, stocks sell off as consumer and business spending begins to slow, because investors anticipate that corporate earnings will deteriorate. Wall Street's slide continues until investors begin to sense that lower interest rates (the only side benefit of recession) will help spark a new economic expansion.

Last week's economic reports provide unambiguous evidence that consumer and business activity is decelerating, and that a recession mind-set is threatening Wall Street and Main Street:

* The National Assn. of Purchasing Management, which tracks manufacturing activity nationwide, reported that its key index plummeted to 46.1% in May from 52% in April. Any index reading below 50 indicates that the manufacturing sector is contracting. The last time the index was under 50 was nearly two years ago.

* The government's chief economic forecasting gauge, the index of leading indicators, fell for a third straight month in April, dragged down primarily by declining orders to factories. A run of three straight down months in the index has historically been a harbinger of recession.

* On Friday, the Labor Department's report that the economy lost a net 101,000 jobs in May--the worst monthly number in four years--shocked most economists. It also stoked concerns that consumers' confidence in their jobs and their future finances may quickly erode this summer, causing spending to slow further and thus making recession a self-fulfilling prophecy.


"The U.S. job picture has gone from lackluster to miserable over the past two months, blowing a wide hole in the good ship Soft Landing," said John R. Williams, chief economist at Bankers Trust Co. in New York.

Whereas the initial stages of the economy's slowdown in January, February and March were attributed largely to a working off of excess business inventories built up during last year's boom times, the pace of deceleration in April and May strongly suggests something more severe is afoot, said Sung Won Sohn, economist at Norwest Corp. in Minneapolis.

"If sales, production and [consumer] income continue to soften, inventories will continue to look burdensome and lead to even further trimming" by businesses, he warns. "The process is not easy to reverse once started."

None of which is even remotely encouraging for corporate earnings, which have been surging for two years--in the process supporting the stock market during last year's interest-rate rise and helping drive share prices to record highs this year.

With earnings now threatened by a recession at worst and a steeper-than-expected economic slowdown at best, is the 4 1/2-year-old bull market breathing its last?

Not in Jeffrey Applegate's view. On Friday, the investment strategist for brokerage CS First Boston Corp. in New York urged clients to boost stock holdings to 60% of assets, up from 40% previously. He also suggested raising bonds to 35% of assets from 30%.

Short-term cash holdings--30% of assets in Applegate's "model" balanced account previously--were slashed to just 5%.

What Applegate is betting on is just about the only thing the bulls can bet on now: that the Fed will begin to loosen credit, and soon.

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